A Letter to Private Equity
The world, if Private Equity abandoned the 2 & 20 model
Private Equity (PE) has been a powerful force in the financial world, promising high returns and transformative changes for the companies it invests in. However, beneath the glossy surface of lucrative returns and financial engineering lies a system fraught with inherent problems
The world, if PE abandoned the 2&20 model
The 2&20 Model: A Recipe for Short-Termism
Fees Over Performance:The 2&20 model is the bread and butter of private equity compensation. It breaks down to a 2% annual management fee on committed capital and a 20% performance fee on profits. This structure aims to align fund managers’ interests with those of investors. In reality, it creates pressure to ‘move upwards’ and have bigger and bigger funds instead of quality of investments.
The Rush for Quick Exits: The 20% performance fee is earned upon exiting investments, pushing managers to sell businesses quickly to realize gains. The pressure to show high internal rates of return (IRR) within a limited timeframe encourages short-term strategies over sustainable growth.
The 10-Year Horizon: A Stranglehold on Growth
PE funds typically operate on a 10-year cycle—5 years to invest, 5 years to divest. This timeline was designed to provide a clear framework for investment and return, but it comes with a huge set of problems.
Forced Buying and Selling: The rigid 10-year cycle leads to "forced buying" and "forced selling." Managers are pressured to deploy capital quickly during the investment period and exit investments within the divestment period, forcing sales at inopportune times, just to comply with the fund’s lifecycle.
Inflexibility: SMEs often need longer time horizons to reach their full potential. The 10-year cycle doesn’t allow for the patience required for sustained investment and strategic development. This lack of flexibility stunts growth and innovation, especially in sectors that evolve slowly or require long-term development cycles.
Focus on Short-Term Metrics: With a finite fund lifecycle, managers focus on metrics that can be quickly improved, like EBITDA, at the expense of long-term investments in R&D, talent development, and market expansion.
See the problem yet?
If not, let’s take a look at how that plays out in practice
The 10-Year Crunch
Operating on a 10-year structure means you have a limited time to buy and sell businesses. So, what do you do after raking in millions from Limited Partners (LPs)? You buy anything that looks like a halfway decent deal, overpay for assets, and accept bad terms. Why take 2% of LPs’ money if you’re not deploying it?
Step 1: Buy Now, Worry Later 💈
You’ve got the deals on your books, and they’re not a complete nightmare. Great! You have 5-8 years (being optimistic here) to profit on the cash-flow before selling the dam thing and returning the money
Step 2: Roll Up, Roll Out 🎢
To boost EBITDA, we bundle a lot of our businesses together and roll them up, often with great disregard for their internal operating structures or whether it makes sense for their unique value propositions. It surely looks good on the books, is good for the company as well?
Step 3: Excel Sorcery 🧙♀️
Because we’re taking 2’n’20, we’re now incentivised to do some fancy Excel magic with our smashed-together spreadsheets. We take fees off mark-to-market or, worse, mark-to-model returns. They’re not realised gains, but trust me, bro, it’s in the sheets, so it will get billed.
Step 4: Get the Lipstick out 💄
As we near the end of our fund’s life, it’s time to sell. We’re forced to let go of some businesses that might be sold way too prematurely. More EBITDA is always better for selling, so we now ‘stick some lipstick on this pig’ (finance quote, don’t crucify me for it) and cut costs relentlessly. Even if the long-term effects mean losing quality and customers, for the first year or two, you’ll pass by.
Why Does This Model Still Exist?
Because very few people have grown the spine to do it differently.
Like the old joke about overpriced consultants that deliver conclusion that ‘happen’ to be the ones the CEO wanted (cough cough McKinsey cough cough) , no allocator at an endowment, family office, or institution is going to lose their job for investing with a big private equity firm that delivers average performance with a conventional structure. Similarly, no one at a big private equity firm is going to lose their job for generating average performance using the conventional model. This status quo bias ensures the persistence of the 2&20 model despite its shortcomings.
What Good Incentives Could Look Like
So, how do we fix this mess? What else is out there? Can we do something better (yes, always). Here’s a neat little idea (I actually ‘borrowed’ from Permanent Equity, my favourite fund out there)
Imagine a private equity model that isn't shackled by the need for quick exits and high leverage. Instead, they have the flexibility to hold investments for generations. This extended time horizon allows companies to grow in value and generate free cash flow, fostering greater prosperity for all involved. It doesn't mean assets are never sold, but sales are driven by strategic considerations rather than time constraints, avoiding high opportunity costs.
This obviously requires aligning incentives properly, why should I give you millions, for you to sit on your hands and do nothing with it? The classic 2&20% model simply doesn’t cut it.
For long-term results, firms need to be pressured to perform above average. One way to ensure this is structuring funds so they only get paid when they generate above-average cash-on-cash returns. If they don't deliver, they don't earn fees. There’s no way for the fund to make money unless their partners make significantly more. And, unless they can buy beer with it, the fund doesn’t get to charge fees on it. 🍻
Alternatives could also be based on profit share mechanisms. I haven’t seen anyone put out an interesting evergreen proposal for funds. But I’m certain there is a way. We’re currently looking at private credit+yearly dividends from cash-flow. We’ll report back how that works.
Let’s build the future, together
The future of private equity can be bright, but it requires a fundamental shift in how we think about investing. Moving away from the quick wins and focusing on sustainable, long-term growth isn't just good for businesses—it's good for society. As the Great Wealth Transfer unfolds, the pressure is on for private equity to evolve.